Session 9. How Much To Spend

Even more than for tax advice, the quality of spending advice depends on the precision with which it reflects your personal situation.  If you want truly useful, customized advice you will benefit from a relationship with a good fee-only financial planner.  However, by these calculations, the sustainable rate of spending is considerably lower than the 4% many advisers recommend.  One suspects that they implicitly allow for deterioration of real wealth, under the principle that "you can't take it with you."

Harvest Time

Source:  US Dept. of Agriculture

In this session, let's assume that you are newly retired, and that you want to conserve the real buying power of your capital.  You will spend everything possible up to that amount.  You've been given a suggested investment plan of 60% municipal bonds, 30% US stocks, and 10% cash equivalents.  You want to check that plan against your initial lifestyle spending plan to see if they are mutually consistent.

A finely-tuned plan would simulate many different scenarios and let you look at the distribution of results.  We don't illustrate it here, but simply assert that there is no such thing as risk-free spending plans.  Any attempt to fix spending at a constant real dollar amount consistent with initial income potential runs the risk that capital may be eroded, forcing an eventual larger cut in spending.  For our explanatory example, we focus on average results, and recommend a spending at a fixed proportion of wealth rather than a real fixed dollar amount.  If you want the latter, you will need to be more conservative than the figures given here.

The inputs we need are the inflation rate, the risk premiums over expected inflation, roughly equal to risk-free interest rates, that the three assets earn on average pre-tax over the long-term, and your tax rates on interest, dividends and long-term gains.

The calculations in the table below are very roughly based on today's numbers for inflation plus long-term averages for risk premiums.  The tax rate assumes this is total income rather than marginal income, and is intended to represent an affluent tax rate with state taxes included.  The low 16% tax rate on capital gains takes into account the material in the preceding session which implied that one could lower the effective tax rate considerably by compounding the unpaid taxes tax-free through lower than average turnover of your stock holdings.  If you insist on trading stocks, count on 20%, or even more if you experience higher short-term capital gains tax rates.

	Cash	Municipal Bonds	Stocks
Inflation	2%	2%	2%
Risk Premium	0%	2%	6%
Interest or Dividends	2%	4%	2%
Tax Rate	30%	0%	30%
Gains	0%	0%	6%
Effective Gains Tax Rate	--	--	16%
After-tax Return	1.4%	4%	6.4%
Real After-tax Return	-0.6%	2%	4.4%

Note that in this example, if one desires to preserve capital, one cannot spend any of the cash interest.  This is a perverse consequence of taxes applied to inflation.

Given an allocation of 10% cash, 60% municipal bonds and 30% stocks, you determine that the maximum long-term sustainable spending rate is -.06% + 1.2% +1.32%.  This amounts to 2.46% of capital.  You will be obligated to spend some of your capital gains from stocks, but this will, on average, be compensated by overall returns.  Again, this is a proportional rate.  It does not insure you against the possibility that your asset base might decline or increase through random fluctuation and you will cut or increase spending proportionately.

Whether this figure is consistent with your spending plans, and with the tax rate assumed, depends on your financial resources.  If 2.46% of wealth would be a lower income than implied by the tax rate assumed, you can improve the example by cutting the tax rate down to reality.  For example, a 15% average (not marginal) income tax rate would raise the real after-tax return on cash equivalents to -0.3%, and on stocks to 4.7%, raising spendable income in this example from 2.46% to 2.58%.  A shift from municipal bonds to higher yield taxable bonds might also help further for someone with a low tax rate.

On the other hand, if you decide that you need more income and are willing to take a chance that it might have to be cut by more later as the stock market fluctuates, you might decide to reallocate your assets toward more equity ownership.  For example, a portfolio 50% in stocks and 50% in municipal bonds might allow you to target a 3.2% spending rate.

The point of these examples is that it takes considerable wealth to support sustainable spending without running down capital.  In light of limited lifetimes, many will choose to allow capital to decline somewhat, or even to purchase an annuity.

Sometimes retirees are tempted to establish mutual fund withdrawal plans on a basis of a fixed dollar per month draw.  Such plans are dangerous.  If done for budgeting convenience they should be reviewed and readjusted at least annually.  In case of unfavorable market results you might otherwise overspend and enter a vicious circle, where fixed spending outflows eat up the principal at an accelerating rate.

The first key concept of this session is that sustainable spending rates are probably lower than you think.  This is especially true during periods of high inflation, because taxes must be paid even on paper profits generated purely by currency inflation.  The second key concept is that spending plans should not attempt to cover up risk, but should be based on constant percentage rules, perhaps readjusted annually.  This assumption of responsibility for the remaining risk in the portfolio makes things more difficult in the very short run and far safer in the long run.

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